May 10, 2013
I am providing comments for Panels 1 & 2. I did the same for Panel 3 earlier this week.
I will collate my series of comments into one document ahead of the June 3 deadline for comments on Rule 4-661.
An introductory question: Has the SEC action against Egan-Jones chilled small firm assessment of ABS ratings?
2011 SEC Proposed Rules for NRSROs - Fortunately Not Yet Implemented
On August 8, 2011, I commented on the 2011 SEC Proposed Rules for NRSROs http://www.sec.gov/comments/s7-18-11/s71811-33.pdf.
The Proposed Rules were poorly conceived. I observed that, had the Proposed Rules been in place prior to the financial crisis, the financial crisis would have been worse. Please see following sections of my August 8, 2011 Comment
. - Section A, pps 3-6
- Section B, pps 6-9
- Section H, pps 35-36
- Section I, pps 36-53.
Alternative rules of a practical and costless nature would better achieve the central aim of Dodd-Frank with respect to rated ABS, namely that ratings and rating processes be made more transparent. Please see following sections of my August 8, 2011 Comment:
- Section B6, p7
- Section E, pps 15-20
- Section G, p24.
I have read all comments submitted in response to the 2011 SEC Proposed Rules for NRSROs. http://www.sec.gov/comments/s7-18-11/s71811.shtml#comments. How does the SEC incorporate previously submitted comments into current analysis?
Most ABS worldwide mis-rated - non-assessed derivative risks cap ABS ratings at low-to-medium investment grade Ongoing narrative on the failure of ABS centers around poor underwriting of assets such as U.S. residential mortgages. The process of producing an ABS has often been described as "slicing and dicing asset flows into rated ABS debt."
In fact, asset flows are generally swapped with an FDIC-insured bank counterparty and the swapped proceeds are "sliced and diced." Rather than "ABS," a more correct acronym is "SWABS," swapped-asset-backed securities.
Bank bail-outs kept upright the ABS domino of event risk from failure of a counterparty to an ABS issuer. Event risk is sizable given the few derivative providers to ABS issuers, the failure of the "replacement" market and the non-enforceability of "flip clauses" under U.S. bankruptcy law.
Non-enforceability of "flip clauses" will obligate ABS issuers to pay unscheduled termination payments on a senior basis to FDIC-insured bank counterparties. Had a major hedge provider entered bankruptcy in 2008 (Lehman was not a major hedge provider to cashflow ABS issuers), senior RMBS debt that fell to $0.30 would have fallen further to $0.10 or less.
Rating agencies assign a probability of zero to event risk under derivative contracts that occupy a senior-most position in ABS priority of payments. Rather than downgrade existing AAA and AA ABS and cap new ratings at A or BBB, rating agencies are ignoring derivative risk and maintaining inaccurate AAA and AA ratings.
Panel 1 should consider "past performance" of NRSROs as if bank bail-outs did not occur and also recognize the circularity of "performance," given that each NRSRO self-monitors its own ratings. NRSROs give themselves and each other a free pass to ignore derivative risk in rating ABS which makes post-2008 performance appear better than the is the case.
Panel 1 should also consider a Big Picture challenge - are NRSROs accountable in any manner? NRSROs implement methodologies without external oversight, evolving legal standards regarding NRSRO free speech don't apply until after injury (i.e. the next financial crisis) and an NRSRO self-monitors its own ratings.
Can NRSROs be required to report rating assumptions across all sectors in a holistic manner? For instance, rating agencies rationalize substantial "rating uplift" to FDIC-insured banks and associated bank holding companies by assuming open-ended government support to bail-out bank bondholders. In a holistic system, the "rating uplift" credit to banks will be offset by a corresponding rating debit to a sovereign rating and neither will be "open-ended." Rather, an NRSRO will estimate the size of future taxpayer assistance for banks both as holders of ABS debt and as counterparties to ABS issuers.
Can an independent body monitor existing NRSRO ratings or comment on forward-looking challenges?
For ABS, "issuer-pay" model more properly termed "arranger/underwriter pays with issuer money"
ABS issuers do not exist, most are post-office boxes in Wilmington Delaware or the Cayman Islands. Rather, ABS arrangers/underwriters act as agent to an ABS issuer with corresponding fiduciary responsibility. ABS arrangers underwriters choose vendors to an ABS closing, such as rating agencies, outside counsel, auditors, collateral managers and agents, paying agents, service rs and note trustees.
With the exception of note trustees, ABS vendors such as rating agencies treat an ABS arranger/underwriter rather than an ABS issuer as client. ABS vendors are paid upfront and in aggregate may claim 2.00% or more of issuer proceeds, i.e. 10 X more than vendors to a corporate bond offering. As a result, ABS start underwater and are structured to be downgraded or even fail.
Can ABS issuers be required to report total closing costs?